There are two types of pension plans.
The first is a defined contribution plan, which is an annuity funded by
periodic contributions. This is valued by determining the current value
of the employee’s contributions on the designated valuation date.
The second type is a defined benefit plan. Valuation of this type
is not so simple, as variables such as salary and length of service must
be taken into consideration.

ISSUE

How is a pension plan to be valued in the context of
equitable distribution of marital property in North Carolina?

RULE

For a defined benefit plan there are
two methods of valuation, the fixed percentage plan and the present value
plan. The choice is up to the court which method to use.

ANALYSIS

Two methods available in North Carolina for determining
equitable distribution of marital property are the fixed percentage method
and the present value method. For the fixed percentage method, the
pension is not valued and the nonemployee spouse is awarded a fixed percentage
of any future payments to be received by the employee spouse. This
percentage is half of the amount of the pension that is marital property.
A coverture fraction is used to determine this percentage, and is the time
the employee spouse participated in the plan during the marriage divided
by the total period of participation in the pension plan. Siefert
v. Siefert used the fixed percentage method to determine the value
of a pension for equitable distribution purposes. The court stated
that the main advantage was the absence of expert testimony, but that the
main disadvantage is a continued connection between the divorced couple.

The present value method can also be used to determine
the value of a pension for equitable distribution, although it is more
complicated. Evidence is used to determine the present value of the pension
on the date of separation, discounted for interest in the future and taking
into account the employee spouse’s life expectancy. Also the percentage
attributable to the marriage period must also be determined. Bishop
v. Bishop used this method and provided a uniform method for courts
to follow when using this method in the future. The coverture fraction
must be first determined. Any part of the pension which is not vested on
the date of separation is classified as separate property. Then the
amount of monthly pension payment to the employee must be determined, assuming
that the employee spouse is retired on the date of separation. This assumption
may lead to a present value less than what it actually is, because salary
will increase the greater the length of service. However, this is
offset by assuming the that employee spouse receives the pension payment
beginning at either the earliest retirement date or the date of separation,
whichever is later. Then the employee spouse’s life expectancy from
the date of separation must be determined, using a specified mortality
table, and used to determine the number of months that benefits will be
received. Next, the present value of the pension at the date of separation
or the earliest retirement date, using a discount rate, must be determined.
The main problem is determining the best evaluation date, either the cutoff
date for acquisition of marital property or the marriage dissolution date.
This method has several advantages. One is that it eliminates risks
to the nonemployee spouse, such that the employee spouse may die, or that
the pension fund may become insolvent. Also, this method allows for
complete separation of the two parties.

The present value method is criticized in that it may
underestimate the value of the pension, thus hurting the nonemployee spouse.
One way it may do this is that the courts to not take into consideration
any increase in benefits paid out due to inflation, such as a cost of living
adjustment. It has been argued that such increases take place after
separation and therefore does not constitute marital property. However,
this is not accurate, because such increases having nothing to do with
the post-separation actions of the employee spouse. Another way that
this method may lead to undervaluation is by assuming that the employee
spouse’s salary at the date of separation is what it will be at the time
of retirement. Such increases could be considered separate property in
that they are due to post-separation actions of the employee spouse. However,
it is argued that this is the same type of appreciation as that of inflation,
and therefore should be taken into consideration. Courts argue that it
all balances out, in that the employee spouse is paying the nonemployee
spouse for rights that may never mature, and therefore it is equitable
to have some factors in the favor of the employee spouse.

Thus, the two methods for valuing pension plans for equitable
distribution after a marital dissolution both have their advantages and
disadvantages, both perhaps leading to an undervaluation of the worth of
the pension plan.

Text

The present value of a spouse’s pension,
along with the family home, are typically the two most valuable assets
that a couple owns. Unlike the home, determining the value of a pension
plan upon divorce is “fraught with uncertainties.”[1]
How a court determines the present value is dependent on what type of pension
plan the spouse has. This paper will focus primarily on defined benefit
plans; how North Carolina courts allow for distributive awards, how courts
determine the present value of pensions and whether the court’s current
methods of determining present value result in an accurate valuation.

There are two types of pension plans.
The first is a defined contribution plan. A defined contribution
pension is essentially an annuity funded by periodic contributions.
At retirement the funds purchase an annuity for the rest of the employee’s
life or an actuarially reduced pension for the lives of the employee and
spouse.[2]
Valuation of a defined contribution plan is fairly simple. The dollar
value is merely the current value of the employee’s contributions as of
the designated valuation date.[3]
In other words, determining the value of a defined contribution plan is
much like determining the value of a person’s stock portfolio. The
court merely takes the number of shares bought by that person and multiply
it by the dollar value of each share.

By contrast, defined benefit plans do not set aside
funds specifically for an individual’s pension benefits. Future benefits
are usually based on formulas which include both salary and length of service
as variables.[4]

North Carolina calls for equitable distribution of marital
property. What that means is that marital property must be valued
and divided. North Carolina includes vested pensions among marital
property.[5]

HOW NORTH CAROLINA ALLOWS FOR DISTRIBUTIVE AWARDS

“Upon application of a party, the
court shall determine what is the marital property and shall provide for
an equitable distribution of the marital property and shall provide for
an equitable distribution of the marital property between the parties.”[6]
The first method available to the courts under this statute is the present
value method which will be discussed in more detail below. The other
method available to the courts is the fixed percentage method.[7]

The fixed percentage method requires
no valuation of the pension. The court simply awards “the nonemployee
spouse a fixed percentage of any future payments the employee spouse receives
under the plan, payable to the nonemployee spouse as, if and when the payments
are received.”[8]
The percentage of future payments is equal to the amount of the pension
that is marital property. That percentage is determined by a fraction,
called a coverture fraction, of which, the numerator is the total period
of time the employee spouse was a participant in the plan within the marriage
(from date of marriage to date of separation) and the denominator is the
total period of the employee spouse’s participation in the plan.[9]

For example, assume a couple gets
divorced before retirement. At the time of separation, that couple
has been married for fifteen years. The wife has been employed at
RJR while married and continues to work at RJR after the divorce.
When she retires, she will have spent a total of twenty years at RJR and
she would have been married to her ex-husband for fifteen of those years.
Assuming she was always a participant in the pension plan, the coverture
fraction is 15/20 or 75%. Assuming wife’s monthly pension at retirement
is $1000, $750 of it is marital property and $250 is separate property.
The husband’s share of the marital property is 50%, so he will receive
$375 monthly from his wife’s RJR pension.

The Siefert court listed several
advantages to the fixed percentage method. Chief among them is the
fact that the use of complicated actuarial evidence and costly expert testimony
that may not produce an accurate valuation are done away with.[10]
The chief disadvantage is the fact that it does not make a “clean brake”
of a potentially acrimonious relationship.[11]

The court can also provide for the
equitable distribution of a defined benefit pension by the present value
method. There, the trial court calculates, using actuarial evidence,
the present value of the vested pension, as of the date of separation,
discounted for interest in the future and taking into account the employee
spouse’s life expectancy. The trial court would further have to compute
the percentage of present value attributable to the marriage period and
the appropriate equitable share to which the nonemployee spouse is entitled.[12]

HOW NORTH CAROLINA COURTS DETERMINE PRESENT VALUE

The leading North Carolina case in
how to determine the present value of a defined benefit pension is Bishop
v. Bishop.[13]Bishop provided a uniform method for the district
courts to follow. These courts were previously using a hodgepodge
of valuation techniques for defined benefits pensions.[14]

As with the fixed percentage method,
the present value method first determines the coverture fraction.
Also, a pension which is not vested on the date of separation is classified
as the separate property of the employee-spouse and is not subject to equitable
distribution.[15]

The first step in the Bishop
methodology is to calculate the amount of monthly pension payment the employee,
assuming he retired on the date of separation, will be entitled to receive
at the later of the earliest retirement age or the date of separation.[16]
This is significant for two reasons. First, by assuming retirement
on date of separation, the court may assign a present value to the pension
less than what it actually is. Salary generally increases as length
of service increases. Therefore, the present value of a pension is
based on a salary that is probably lower than what it will be at retirement
or separation from the company. That calculation could likely understate
the present value of the nonworking spouse’s share of that pension.
That understatement is offset somewhat by the fact that present value is
calculated assuming the working spouse is entitled to receive the pension
payment at the later of the earliest retirement date or the date of separation.
The earlier a person is entitled to receive pension payments, the greater
the present value of that entitlement. That is so for two reasons.
First, the period of time over which any benefits must be discounted gets
shorter. Second, as the total period of time over which benefits
will be collected lengthens, the total amount collected will be larger.[17]
It is true that some early retirement options have benefit penalties, but
often there are no penalties, as many employers wish to encourage employee
turnover among higher paid senior employees.[18]

The second step, according to the
Bishop
court, is to determine the employee spouse’s life expectancy as of the
date of separation and use this figure to ascertain the number of months
the employee-spouse will receive benefits under the plan.[19]
There are a number of mortality tables to choose from, but the Bishop
court demands that courts use the tables of the Pension Benefit Guaranty
Corporation (PBGC), a division of the United States Department of Labor.[20]

The third step is to determine the
then-present value of the pension as of the later of the date of separation
or the earliest retirement date using an acceptable discount rate.
The Bishop court again says to use the interest tables of the PBGC
to determine the discount rate.[21]
That raises the question, left unanswered by the Bishop court, of
what the appropriate evaluation date is. Some pension estimators
believe that the correct evaluation date is the cutoff date for the acquisition
of marital property, while others commonly use the marriage dissolution
date. This is not a trivial issue, as the two dates may be widely
separated in time, leading to a large difference in the potential discount
rates.[22]
Finally, if the earliest possible retirement date does not match the date
of separation, then the date of separation present value of the pension
must be determined.[23]

Let us use a hypothetical to apply
Bishop
to a current divorcing couple. Marge (the nonworking spouse) and
Homer (the working spouse) have been married for 12 years. At the
time of separation, Homer has been working at the nuclear power plant for
20 years. Homer has been working at the power plant for the entire
12 years he has been married to Marge. At the time of separation,
Homer is 40 years old. Homer could take his pension as early as age
50. If Homer retired on the date of separation he would be entitled
to $1000 monthly. Homer is expected to live another 30 years.

The first thing to do is determine
the coverture fraction. The coverture fraction is 12 divided by 20,
or 60%. That means that 60% of Homer’s pension is marital property.
Marge is entitled to half of that marital property, or 30% of the present
value of Homer’s pension.

Next, the court must determine the
monthly pension Homer is entitled to if he were to retire on the date of
separation. As previously stated, that amount is $1000. Next
the court must determine the probable number of months Homer will receive
benefits under the plan assuming he is to receive benefits on the earliest
possible date. The probable number of months Homer will receive benefits
under the plan is 240 months. Homer will receive benefits at age
50 and will continue to receive them for another 20 years or 240 months,
at which time the PBGC expects Homer to die. The next task for the
court is to determine the present value of that stream of payments as of
the earliest retirement date. Let’s assume for the sake of simplicity
that the PBGC discount rate is 12%, or 1% monthly. The present value
of that stream of payments is

PV = Pymnt x[(1+i)<n>-1]/[(1+i)<n>xi)]

where

PV = the present
value

Pymnt = the payment made at the end
of each of n periods

i = the discount rate for each period
(12%/12, or 1%)

n
= the number of periods (20x12, or 240)

Applying the
above formula to our hypothetical, the court will come up with a present
value of $90,819.42. The next step is to determine the value of $90,819.42
to the date of separation. To make this determination we will again
use the discount rate provided by PBGC. We will also need to make
a further mortality discount to account for the possibility that Homer
might not live to age 50, the earliest point at which he can begin to receive
his pension benefits.

Doing the interest
discounting first, our formula is

PV = FV/(1+i)<n>

where

PV = the present
value

FV = future
value at the end of n periods

i = the interest
rate paid each period

n
= the number of periods

Applying the
above formula to our hypothetical, the court will determine the present
value as of the date of separation to be $27,517.81. Let’s also assume
that according to the PBGC mortality tables, Homer has an 80% chance of
living until 50. If we take the present value of $27,517.81 and multiply
it by 80% we come up with $22,014.25, which represents the present value
discounted to the date of separation. Next we take the coverture
fraction, which is 60% and multiply it by $22,014.25 to come up with $13,208.55
which represents the present value portion of Homer’s pension that is marital
property. Finally, Marge is entitled to half the marital property,
so Marge is entitled to $6,604.28 of Homer’s pension.

This $6,604.28
is an immediate offset, so Homer must give Marge $6,604.28 in other property
to compensate Marge for giving up her share in pension benefits.[24]

North Carolina
courts have listed several advantages to the present value method.
First, the nonemployee spouse avoids the risk that the pension fund may
become insolvent, or the employee spouse might die before he is eligible
to receive his pension. Second, the present value method terminates
litigation sooner and lets the two parties go their separate ways.
Finally, the present value method precludes the nonemployee spouse from
sharing in post-separation increases in pay which may result in higher
pensions.[25]
One disadvantage to the present value method is that the employee spouse
has to pay the nonemployee spouse for a benefit that may never mature.[26]
The major criticism of the present value method is that it consistently
underestimates the value of the pension, prejudicing the nonemployee spouse.[27]

DOES THE PRESENT VALUE METHOD UNDERVALUE DEFINED BENEFIT
PENSIONS?

As mentioned
earlier, North Carolina courts use the amount of pension the employee spouse
is entitled to at the time of separation as their baseline number in determining
the present value of the pension. However, the courts neglect to
figure in any increase in pension benefits paid out due to inflation.
For example, pensions of most public employees include a “cost of living”
adjustment (COLA) tied to the Consumer Price Index (CPI). If a public
employee were receiving a pension of $1000 monthly in 1999 and the CPI
recorded inflation of 5% for that year, then the employee’s pension for
the year 2000 will be $1050 monthly. Although most private employers
do not explicitly grant a COLA, empirical data shows that inflation adjusted
increases were roughly 40% of CPI for private defined benefit pensions.[28]

Given the common
practice of employers to include COLAs in their defined benefit pension
programs, the court’s failure to take this into account causes the present
value of the pension to be undervalued. The argument that such increases
took place after separation and are not marital property is untenable.
Unlike benefit increases due to an increase in salary, increases attributable
to a COLA have nothing to do with post-separation actions of the employee
spouse and are thus not separate property. An increase in the value
of a pension due to a COLA increase is called “passive appreciation.”[29]
Nothing in the North Carolina statutes prohibit a court from allowing the
nonemployee spouse to capture this post-separation passive appreciation.
To the contrary, such capture is expressly allowed.[30]
Others argue that trying to determine an average annual COLA over the employee
spouse’s retired life is an exercise in futility. Clearly, estimating
an accurate COLA is a difficult task. However, the estimate the court
does come up with is not likely to be any more inaccurate than the current
practice of estimating a COLA of 0%. If courts continue to apply
the present value method, equity demands courts account for COLAs.

Another way
courts undervalue defined benefit pensions is to assume for purposes of
the valuation that the employee spouse’s salary at date of separation is
equal to what the spouse’s salary will be at time of retirement.
The justification for this is that any post-separation raises are the separate
property of the employee spouse. However, there are two arguments
against that justification. First, in many cases, raises are automatic
with increased seniority. Therefore, like COLA’s, such raises can
be seen as passive appreciation. As mentioned before, the nonemployee
spouse may capture this post-separation passive appreciation. Second,
the employee spouse would not be in a position to enjoy his current post-separation
salary were it not for the efforts of his former spouse. In that
sense, the nonemployee spouse can be seen as “laying the foundation” for
the employee spouse’s financial well-being. Equity demands that the
nonemployee spouse be entitled to enjoy the fruits of her labor.
Therefore, the salary that the present value of the pension is based on
should be higher than what it is at time of separation.

Courts will
argue that the valuation biases in the favor of the employee spouse are
justified. The argument goes that since the employee spouse has to
pay the nonemployee spouse for rights that may never mature, it is equitable
to utilize some valuation factors that are more favorable to the employee
spouse. Remember that the employee spouse must be vested in his pension,
otherwise the pension is considered the separate property of the employee
spouse. Therefore, the only two things that could keep the employee
spouse from retiring and collecting money off his pension are death and
the risk of employer default. As to the possibility of pre-retirement
death, that is expressly figured in discounting the present value of the
pension at the time of the employee’s earliest possible retirement to the
present value at the date of separation through the PBGC mortality tables.

Courts also
cite the possibility that the employer will default on the defined benefit
pension plan.[31]
Such concerns are unfounded because of the passage of the Employee’s Retirement
Income Security Act of 1974 (ERISA). Under ERISA guidelines, the
PBGC guarantees payment of pension benefits in the event of default by
the private employer.[32]
For public employees, risk of default is almost nonexistent because of
the government’s ability to tax to pay for its liabilities. Therefore,
once an employee spouse is vested under his employer’s pension plan, payment
is a near certainty, whether payment is by the employer or the PBGC.

Clearly, the
court’s current method of valuing defined benefit pensions nearly always
results in a substantial underestimate of the present value of pensions.
As a result, the nonemployee spouse is not receiving an equitable distribution
of what is perhaps the most substantial asset the couple owns. Unless
courts are willing to factor in COLAs and value the pension based on a
figure higher than the employee spouse’s salary at the time of separation,
courts should exclusively utilize the fixed percentage method as a matter
of fairness to the nonemployee spouse.

[28]Seeid.
at 212.[29]Id.
at 213.[30]
According to the North Carolina Equitable Distribution Statute, “[t]he
award shall include gains or losses on the prorated portion of the benefit
vested at the date of separation.” N.C. GEN. STAT. §50-20(b)(3)(d)
(1995).[31]SeeBishop,
440 S.E.2d at 595.[32]
29 U.S.C. § 1081 (1994).